Basic Principles of Capital Budgeting | CFA Level 1 - AnalystPrep (2024)

FAQs

Basic Principles of Capital Budgeting | CFA Level 1 - AnalystPrep? ›

The five principles are; (1) decisions are based on cash flows, not accounting income, (2) cash flows are based on opportunity cost, (3) The timing of cash flows are important, (4) cash flows are analyzed on an after tax basis, (5) financing costs are reflected on project's required rate of return.

The five principles are; (1) decisions are based on cash flows, not accounting income, (2) cash flows are based on opportunity cost, (3) The timing of cash flows are important, (4) cash flows are analyzed on an after tax basis, (5) financing costs are reflected on project's required rate of return.

The typical steps in the capital budgeting process are: 1) generating ideas, 2) analyzing individual proposals, 3) planning the capital budget, and 4) monitoring and post-auditing.

Level 1 CFA Exam Takeaways for Capital Allocation

Capital allocation is a process carried out to make decisions on investment projects lasting over a year. Capital budgeting (allocation) can be divided into four steps: idea generation, investment analysis, capital allocation planning, and monitoring and post-auditing.

The NPV rule states that all projects with a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those with the high discounted value should be accepted.

Capital budgeting involves identifying the cash in flows and cash out flows rather than accounting revenues and expenses flowing from the investment. For example, non-expense items like debt principal payments are included in capital budgeting because they are cash flow transactions.

Structure of the exam

The CFA Level 1 exam consists of 180 multiple-choice questions, divided into two parts, each containing 90 questions. Candidates have 2 hours and 15 minutes to complete each part, making the total exam duration 4 hours and 30 minutes, including an optional break between the two parts.

The process of capital budgeting involves the steps like Identifying the potential projects, evaluating them, selecting and implementing the projects, and finally reviewing the performance for future considerations.

What are the seven 7 process in capital budgeting? ›

What are the seven capital budgeting techniques? The seven techniques include net present value (NPV), internal rate of return (IRR), profitability index (PI), payback period, discounted payback period, modified internal rate of return (MIRR), and real options analysis.

If there are more than one project with positive NPV's the project is selected whose NPV is the highest. The formula for NPV is NPV= Present value of cash inflows – investment. Co- investment C1, C2, C3… Cn= cash inflows in different years. K= Cost of the Capital (or) Discounting rate D= Years.

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

The target capital structure of a company refers to the capital which the company is striving to obtain. In other words, target capital structure describes the mix of debt, preferred stock and common equity which is expected to optimize the stock price of a company.

Level 1 CFA Exam: Liquidity Ratios

They also help us assess how quickly the company can convert assets into cash. Current ratio is an example of liquidity ratio. Where, liquidity is the company's ability to meet its short-term obligations. Quick ratio is an example of liquidity ratio.

The separation principle is the principle of capital budgeting which asserts that the calculations of cash flows for a project should remain independent of financing. The separation principle is an important concept in corporate finance.

based on the preference of the management team. Over the life of an asset, total depreciation will be equal to the net capital expenditure. If a company regularly has more CapEx than depreciation, its asset base is growing.

The ten principles are:

Ensure that budget documents and data are open, transparent and accessible. Provide for an inclusive, participative and realistic debate on budgetary choices. Present a comprehensive, accurate and reliable account of the public finances. Actively plan, manage and monitor budget execution.